The objective of this exercise is to take a more conservative approach at the cost/benefits analysis of a project; and, then change the resulting negative NPV to zero by lowering the software price we are willing to pay.

Two documents are included:

The MS Word document describes the proposal in the upper half; and, then tells you the changes your boss wants you to make on the spreadsheet. Once you have made the changes, he/she wants you to change the price of the software until NPV comes down to zero for the project.

The Excel spreadsheet shows the analysis you made for the original proposal. Please use the same spreadsheet to make the changes asked for by your boss, and figure out the price you want to negotiate for the software, by lowering the software price until NPV drops down to zero.

Cost benefit analysis for the Long Engineering Company

The Long Engineering Company (LEC) has decided to install a network system to help their technical support engineers (five of them who earn an average of $100,000 each per year) to deliver better customer service including: mail out sales and other literature, answer phone calls for technical assistance and log and forward repair requests using an alpha-numeric paging system that will be part of the new network system. Currently all company technical manuals are in physical format, but will need to be scanned and converted to electronic readable form. There are about 3000 pages of technical literature. The initial feasibility study estimated that there would be savings in various areas including: (1) there are currently four clerical staff, two of these would no longer be needed ($60,000 per year each), and (2) Reduced long distance toll bills of $1,500 per month for calls to field support staff regarding repair requests. It was also expected that there would be an increase in sales of $400,000 per year because of improved customer service, with a gross profit rate of 40%. The company typically uses a cost of money (discount rate) of 20% for these types of projects.

Ten months ago, our company's IT consultant/vendor gave us the following proposal, and we
prepared an Excel spreadsheet (see separate handout) showing a Net Present Value of $257,605 for
the project:

"Our system will provide a full LAN configuration for your customer support services area covering the major areas of functionality required including: call logging by customer or inquirer, recording of nature of request and nature of response, access to all company technical literature online, and automatic message forwarding to hand-held devices of field service persons where necessary. The cost of the system includes the required file server and six workstations, laser printer and WAN communications adapter ($150,000). The software provided will include the necessary LAN operating system (Windows), and applications software to meet the functionality requirements mentioned above ($175,000). Existing staff should be able to handle the new system with additional training, as the entire system will be very user friendly with a low learning curve and should be easily administrated by one of the existing engineers, only absorbing 20% of his/her time. We do recommend that you budget for at least one week of training for each of your employees each year to gain and maintain the skills necessary to achieve full benefit from this system. It will also be necessary to budget for the conversion of the company's technical literature at an estimated cost of $5 per page. A maintenance contract is available if you wish at a cost of 15% of the initial cost of the hardware, and a similar contract is available for the software. Training costs typically amount to $2500 per week, per employee."

Assignment:

The financial situation of the company has changed substantially since we first analyzed the proposal; your manager wants you to make changes to the previous Excel spreadsheet. A more conservative analysis should include the following changes:

1. Assume that the engineer/supervisor who will be administering the system will have to devote 50% of his/her time the 1st year, 40% the 2nd year, 30% the 3rd year, and 20% the 4th and 5th years of the analysis. Hint: It is customary in business to allocate to the project the portion of a resource's cost/salary in direct relationship to the % of time the resource devotes to it.

2. Assume that the anticipated sales increase will be only $200,000 the 1st year, $300,000 the 2nd year, and $400,000 the remaining 3 years of the study.

3. Assume the gross profit rate will only be 20% throughout the study.

4. If the resulting new Net Present Value (NPV) is negative, your manager wants you to renegotiate the initial cost of the software to an amount which will bring NPV to zero (0) for the project.

5. What should the new cost of the software be, if you want the NPV of the project to be Zero?